Dividend Tax Hike? Don't Sweat It!

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Includes: BAC
by: Lou Basenese

About two weeks ago, I did my best to dispel the rumors about a bubble in dividend-paying stocks. One reader wasn't buying it, though. "You totally forgot about the dividend tax hike, Lou. It's going to ruin dividend investing!"

Au contraire, mon frère. I didn't forget about it. It's just that the dividend tax hike doesn't really matter when it comes to dividend stock prices. Here's why…

Higher Taxes Here We Come… or Not!

As you're probably aware, the dividend tax rate, which is currently capped at 15%, is set to expire at the end of this year. And unless Congress acts, the maximum dividend tax rate will revert to 39.6%.

If we add in the 3.8% tax on investment income, which was part of the 2009 healthcare overhaul, top earners could be paying a whopping 43.4% tax on dividends. The potential impact? A 7% pre-tax yield would only yield 3.96%, instead of 5.95% on a post-tax basis.

Ouch!

Or as The Wall Street Journal's Jack Hough says, "Higher dividend taxes could take some luster off dividend-paying stocks."

Let me assure you, though. Higher taxes are not going to lead to a collapse in prices. For one thing, many investors - across all income tax brackets - own a large portion of dividend stocks in tax-advantaged accounts. So they won't feel the sting of a tax increase one bit.

Moreover, only the highest earners would be subject to the highest rates. And they only account for a small percentage of the population. I'm not saying that it's acceptable to tax the rich more. But what I am saying is this: Companies aren't going to hold off on increasing dividends just because a small percentage of investors are impacted.

Read My Lips: No New Taxes

Amidst all the hullaballoo about a possible dividend tax hike, investors keep forgetting 2012 is a re-election year. And raising taxes never wins votes. I'm convinced all the worry is going to amount to nothing more than just that - a whole lot of worry.

To garner political favor, Congress will most likely pass a short-term extension of the current dividend tax rate. It's the path of least resistance, just like the Alternative Minimum Tax (AMT) Patch, which keeps getting extended again and again and again.

Even if Congress defies political wisdom and raises taxes during an election year, recent research proves we still shouldn't fret about dividend stock prices.

Survey Says: Dividend Growth, Not Taxes, Matters Most

Just because companies increased dividend payments dramatically after the 2003 tax cut doesn't mean the two are linked. In fact, according to the latest research, no correlation exists between tax rates and dividend payments…

  • A recent study by Nuveen Investments found that "there has seemingly been no correlation between the performance of dividend-paying stocks and the tax treatment of dividends."
  • Analysis by Savita Subramanian, head of U.S. equities at Bank of America (NYSE:BAC), arrived at a similar conclusion. She found there is "no evidence that the change in the dividend tax rate had any significant impact on the relative performance of dividend-oriented strategies."

If taxes don't matter for dividend stock prices, what does? According to Ms. Subramanian, it's dividend growth. She says it matters much more than tax rate changes in determining future stock prices.

Now you know why I tell you to "go with dividend growers" in my "Seven-Step System to Finding the Safest High-Yield Stocks in Any Market." Specifically, consider companies that have increased their dividend for at least 10 years. Their higher and higher dividend payments often lead to higher and higher stock prices, too.

Bottom line: Even if dividend tax rates climb, history proves the dividends won't stop flowing. So don't sweat it. Just stick with dividend growers.